5 Reasons to Worry About Stocks, and Why They Don’t Make Sense

Wells Fargo analyst Ohsung Kwon took a skeptical look at the bear case for stocks. (Michael Nagle/Bloomberg)

Key Points

• A drop in Wells Fargo’s Sentiment Indicator may have triggered a Buy signal, which historically has pointed to gains for stocks.
• Concerns about liquidity are easing as the Treasury General Account reached $1 trillion and quantitative tightening concludes.
• A potential Federal Reserve interest-rate cut, currently priced at 63% odds for December, could broaden stock market gains beyond AI-focused companies.

You’ve heard of Goldilocks and the three bears, but not even five growling beasts can disrupt this rally.

That is according to Wells Fargo strategist Ohsung Kwon. He wrote on Tuesday that a sharp drop in the firm’s Sentiment Indicator last week has likely triggered a Buy signal. Historically, when that happens the S&P 500 has rallied an average of 7.5% over the next three months, rising more than 90% of the time. Likewise, he said, the government reopening would help stocks as the third-quarter earning season wraps up.

Yet investors don’t have to count on those factors. Kwon pooh-poohs five bear cases that are rattling some investors.

The first concern is that liquidity is tight. “It was, led by a big Treasury General Account refill absorbed by the market,” Kwon wrote, referring to the need to replenish the government’s checking account after this summer’s battle over the cap on federal borrowing. Funding the account by selling Treasury debt means there is less cash to put to work elsewhere in the financial system.

Now that the general account has been refilled to $1 trillion—the highest level since the pandemic era—and quantitative tightening is coming to end, that headwind is mostly in the rearview mirror. Liquidity conditions are poised to get better, not worse.

Secondly, there are worries about the health of the consumer and layoffs. While those may well be justified, they could prompt the Federal Reserve to cut interest rates next month, he said. Prices of interest-rate futures point to only 63% odds of a December rate cut, so markets are likely to rally when the reduction comes. Gains likely would come from a broader group of stocks than the artificial-intelligence stars that have lifted the S&P 500 so far this year.

At the same time, a tough holiday season in terms of retail sales could act as a “clearing event,” for consumer stocks, when the market absorbs all the bad news so it can move forward. Many consumer shares are trading cheaply as well. If these “companies reset expectations enough when they report over the next few weeks,” that could be a buying opportunity, he said.

A third concern is the market’s near straight shot upward since the Liberation Day scare in the spring. While that spectacular ascent has some market watchers warning that stocks are due for a a meaningful correction, downturns are part of a healthy bull market.

“We heard from bank CEOs that the market could potentially see 10%+ sell-offs over the next one to two years,” Kwon writes. “That’s not necessarily a bearish call, but just the norm. Since 1950, 10%+ corrections have occurred 0.8 times per year on average.”

Then there is the question of whether the huge amounts of capital being spent by AI hyperscalers are truly necessary for innovation. Skeptics might argue that Big Tech is overspending to keep up appearances of being on the leading edge, at the expense of free cash flow? Now that even big companies are funding capex with debt, it is a more pressing issue.

Kwon believes those doubts simply mean investors should shift their focus to AI infrastructure stocks because they will benefit from this long-lived investing cycle regardless of what it yields for the likes of OpenAI.

Finally, while valuations are undeniably high, “valuation is only half the equation,” Kwon says. Like many other strategists, he points to the fact that rising profits can lift stocks even if valuations remain where they are now. If earnings per share grow at 10% a year over the next five years, then the S&P 500 should generate an 8% total return per year, meaning it could end 2030 at 9500.

With the index near 6850 on Tuesday afternoon, that is hardly an unbearable scenario.

Write to Teresa Rivas at teresa.rivas@barrons.com